Tax Administration: Recurring Issues in Tax Disputes Over Business
Expense Deductions (Letter Report, 09/26/95, GAO/GGD-95-232).

Pursuant to a congressional request, GAO identified the issues that
cause the most frequent disputes between the Internal Revenue Service
(IRS) and taxpayers in connection with section 162 of the tax code.

GAO found that: (1) of the 185 Tax Court petitions reviewed, sole
proprietors, small- and medium-sized corporations, and individuals
claiming employee business expenses disagreed with IRS most often over
the adequacy of documentation for a given expense deduction; (2) 47
percent of the petitions involved questions of proper documentation of
all types of deductions, particularly for entertainment, travel, meals,
and automobile expenses; (3) while sole proprietors most often disputed
documentation issues, small- and medium-sized corporations frequently
contested IRS decisions on the reasonableness of executive salaries; (4)
although executive compensation disputes accounted for only 14 percent
of the petitions, they accounted for about 50 percent of the total
proposed tax adjustments; (5) documentation disputes accounted for 19
percent of the total proposed tax adjustments; (6) in the 117 Office of
Appeals cases reviewed, large corporations' capital expenditure disputes
accounted for 42 percent of the contested issues and almost 58 percent
of the total proposed tax adjustments; and (7) corporate documentation
and executive compensation disputes constituted 8 percent and 3 percent,
respectively, of the Appeals cases.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GGD-95-232
     TITLE:  Tax Administration: Recurring Issues in Tax Disputes Over 
             Business Expense Deductions
      DATE:  09/26/95
   SUBJECT:  Tax administration
             Agency proceedings
             Income taxes
             Expense claims
             Appellate procedure
             Tax law
             Documentation
             Executive compensation
             Taxpayers
             Tax return audits
IDENTIFIER:  IRS Coordinated Examination Program
             IRS Appeals Coordinated Issue Program
             IRS Industry Specialization Program
             IRS Large Case Program
             IRS CENTAUR Issue Tracking System
             
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Cover
================================================================ COVER


Report to the Chairman, Subcommittee on Oversight, Committee on Ways
and Means, House of Representatives

September 1995

TAX ADMINISTRATION - RECURRING
ISSUES IN TAX DISPUTES OVER
BUSINESS EXPENSE DEDUCTIONS

GAO/GGD-95-232

Recurring Issues in Tax Disputes

(268647)


Abbreviations
=============================================================== ABBREV

  GGD -
  IRS - Internal Revenue Service

Letter
=============================================================== LETTER


B-260158

September 26, 1995

The Honorable Nancy L.  Johnson
Chairman, Subcommittee on Oversight
Committee on Ways and Means
House of Representatives

Dear Chairman Johnson: 

Every year the Internal Revenue Service (IRS) audits the tax returns
of over one million taxpayers, adjusting the tax liability of
taxpayers who IRS believes do not comply with provisions of the
Internal Revenue Code (tax code).  Taxpayers may challenge IRS'
proposed adjustments by filing a protest with the IRS Office of
Appeals or filing a petition with the U.S.  Tax Court. 

Former Chairman J.J.  Pickle asked us to identify the issues that
caused the most frequent disputes between IRS and taxpayers in
connection with section 162 of the tax code.  Section 162 allows
taxpayers to deduct from income "ordinary and necessary" expenses
related to trade or business.  We had previously reported that
section 162 was the tax code section most commonly cited in large tax
cases at the IRS Office of Appeals.\1

To do the requested analysis, we reviewed 185 Tax Court petitions
filed in 1993,\2 mostly by sole proprietors and small and
medium-sized corporations, as well as partnerships, individual
shareholders, and individuals claiming employee business expenses. 
We also reviewed 117 Office of Appeals cases filed by large
corporations.\3


--------------------
\1 Tax Administration:  Recurring Tax Issues Tracked by IRS' Office
of Appeals (GAO/GGD-93-101, May 4, 1993).  This report identified
sections of the tax code that were the frequent subjects of large
cases in the Office of Appeals. 

\2 We used 1993 petitions because this was the only year where all
data, including an index identifying the tax code sections in
dispute, were available. 

\3 By large corporations, we mean the 1,700 largest corporations that
IRS audits under a special program, the Coordinated Examination
Program.  The 117 cases also included any cases where the proposed
tax adjustments exceeded $10 million, regardless of corporate size,
plus some cases where the proposed adjustment was between $1 million
and $10 million and where the issue in the case was one tracked by
IRS in its Appeals Coordinated Issue Program or its Industry
Specialization Program.  The 117 large cases were in the Office of
Appeals' open inventory as of September 1994. 


   RESULTS IN BRIEF
------------------------------------------------------------ Letter :1

In the 185 Tax Court petitions we reviewed, sole proprietors, small
and medium-sized corporations, and individuals claiming employee
business expenses disagreed with IRS most frequently over the
adequacy of documentation for a given expense deduction.  About 47
percent of all the issues in the petitions we reviewed involved
questions of proper documentation.  These disputes were especially
frequent where the documentation requirements were the most
rigorous--entertainment, travel, meals, and automobile expenses. 
This rigor comes about because section 274 of the tax code adds other
evidentiary tests to the ordinary and necessary standard. 

While documentation was the issue sole proprietors disputed most
frequently, small and medium-sized corporations contested IRS'
decisions on the reasonableness of executive salaries as frequently
as they did documentation.  Under the tax code, a taxpayer may only
deduct a "reasonable allowance" for salaries.  IRS generally
challenges closely held corporate\4 taxpayers when their salaries
appear excessive.\5

Overall, the frequency of disputes over unreasonable executive
compensation was far less than disputes involving documentation of
business expenses--14 percent versus 47 percent.  However, executive
compensation accounted for about 50 percent of the total proposed tax
adjustments--$24.5 million of $48.8 million--in the petitions we
reviewed.  Adequacy of documentation was the second largest category
at $9.3 million.  (See app.  I for more information about the issues
in dispute in the petitions we reviewed.)

In the 117 Office of Appeals cases, large corporate taxpayers
disagreed with IRS most frequently over the issue of capital
expenditures, which accounted for about 42 percent of the issues they
contested.  It was also the issue with the most dollars at stake in
the 117 cases, accounting for $1.1 billion of the total $1.9 billion
in proposed tax adjustments.  In these cases, the corporations argued
for immediate deduction of large expenses related to events such as
corporate mergers, reorganizations, or environmental cleanups.  IRS
contended that such expenditures had future benefits and should
therefore be treated as capital expenditures, not immediately
deductible in the current tax year.\6

All of the other issues the large corporations disputed were
contested far less frequently than the issue of capital expenditures. 
Documentation questions accounted for only 8 percent of the issues
contested.  Unreasonable executive compensation accounted for 3
percent of the issues and 1 percent of the proposed adjustments. 
(See app.  II for more information about the issues in dispute in the
Office of Appeals cases we reviewed.)


--------------------
\4 "Closely held corporations" are privately owned corporations with
a relatively small number of shareholders. 

\5 In the cases of closely held corporations, IRS almost always
argues that any amount of salary considered excessive is a "disguised
dividend"--a distribution of profits.  Corporations may deduct
salaries as business expenses but no deduction is available for
dividends. 

\6 Costs of capital expenditures are added to the basis of the
property involved in the transaction.  Depending on the property, the
costs are generally either depreciated over a period of years or used
to reduce the gain on the disposition of the property.  Therefore, if
capital improvements are made to a building, these may be depreciated
over the life of the building.  However, if capital improvements are
made to land, the tax benefit is obtained only when the owner
disposes of the land. 


   BACKGROUND
------------------------------------------------------------ Letter :2

Section 162 of the tax code allows taxpayers to deduct from income
ordinary and necessary expenses related to a trade or business. 
Taxpayers report these deductions to the IRS in various ways on their
tax returns. 

When IRS audits taxpayers, it frequently challenges deductions of
business expenses as not being in compliance with section 162.  As we
reported in May 1993, section 162 was the code section most commonly
cited in large tax cases at the Office of Appeals. 

When taxpayers disagree with IRS' audit findings, IRS advises them by
letter that they have 30 days in which to file a protest requesting a
conference with the IRS Office of Appeals.  If the taxpayer and the
Office of Appeals cannot reach an agreement or if the taxpayer waives
the right to an Office of Appeals conference, IRS issues a statutory
notice of deficiency, a so-called "90-day" letter.  On receipt of the
letter, taxpayers have 90 days in which to petition the Tax Court for
relief. 

The Tax Court notifies IRS when it receives a taxpayer's petition,
and the Office of Appeals generally has the authority to settle the
case at any time before the scheduled court trial.  When the Office
of Appeals has previously dealt with the petitioner, IRS' Office of
the Chief Counsel assumes jurisdiction over the case.  According to
the Office of Appeals, roughly 90 percent of all its cases are
settled administratively without court litigation. 

In fiscal year 1993 and again in fiscal year 1994, the Office of
Appeals received over 65,000 cases for settlement.  Approximately
two-thirds of these cases came from protests filed directly with the
Office of Appeals, while the remaining one-third originated with
petitions filed with the Tax Court. 


   OBJECTIVE, SCOPE, AND
   METHODOLOGY
------------------------------------------------------------ Letter :3

Our objective was to identify the types of disputes commonly
occurring between taxpayers and IRS under section 162 of the tax
code.  We defined disputes as cases where the taxpayers protested to
IRS' Office of Appeals or petitioned the Tax Court.  We realize that
taxpayers may disagree with IRS' proposed adjustments but not file
protests or petitions.  However, there is no practical way for us to
define such a universe to review.  Except for its largest cases, IRS
does not routinely track recurring issues in taxpayer cases.  For its
Large Case Program, which involves the largest corporate taxpayers or
tax adjustments exceeding $10 million, the Office of Appeals
maintains an issue tracking system, CENTAUR.  Our May 1993 report on
recurring tax issues focused on issues in the large tax cases and
used data from CENTAUR.  In this report, we included large cases but
also expanded our review to include IRS' disputes with smaller
businesses and individuals by using information from 1993 Tax Court
petitions. 

To create our sample of Tax Court cases, we used a database of 1993
Tax Court petitions and an index to these petitions, both of which
were published by Tax Analysts.\7 This index identified 795 petitions
filed in 1993 involving section 162.  To determine the most
frequently recurring reasons for disputes, we obtained all 226
petitions filed between January 1 and May 17, 1993, and other
documents filed with the petitions.  Although these petitions were
filed during the January through May time period, the dates they were
filed did not determine the issues that were contested.  Because of
this random nature, we have no reason to believe the issues in these
petitions would differ from issues contested at other times during
1993. 

However, we were unable to use all 226 petitions.  For 41 petitions,
the information was insufficient for us to categorize the reasons
(e.g., documentation, executive compensation) for the disputes.  Our
results are from the remaining 185 petitions in which the information
was sufficient. 

We examined CENTAUR data to identify the most frequent section 162
issues in large tax cases.  For the CENTAUR system, which tracks
appealed cases, IRS personnel classify the major issues in each case
and summarize the dispute.  We reviewed data for all 117 cases that
were from IRS' western and southeast regions and in an "open" status
as of September 1994.  We judgmentally selected these two regions on
the premise that the types of large corporations located in each, and
therefore the issues they may contest, would differ.  We thought that
such differences would give us a better cross section of the issues
large corporations dispute. 

In reviewing the 185 Tax Court cases and the 117 Office of Appeals
cases, we did not assess whether the taxpayer or the IRS was correct
in the position they took on the issues.  Neither did we ascertain
how the cases were resolved. 

We asked IRS' Office of Examination and Office of Appeals to review
our preliminary results.  In responding to our request, the Office of
Examination reviewed its database on issues in the Coordinated
Examination Program, and the Office of Appeals reviewed its CENTAUR
database.  Both of the offices developed findings that were generally
similar to ours. 

We did our work in Washington, D.C., and Laguna Niguel, CA, between
August 1994 and March 1995 in accordance with generally accepted
government auditing standards. 

We requested comments on a draft of this report from the Commissioner
of Internal Revenue or her designee.  We met with IRS National Office
officials to obtain their comments on August 18, 1995.  IRS
representatives at that meeting included the Office of Appeals'
Director of Large Case Programs and the Office of Examination's
National Directors of the Office of Corporate Examination and the
Office of Compliance Specialization.  The IRS officials agreed with
the information presented in this report. 


--------------------
\7 Tax Analysts, a private company, routinely publishes texts of
petitions and other documents filed with the Tax Court in connection
with its publication Tax Practice & Controversies.  In April 1994,
Tax Analysts also published Index to U.S.  Tax Court Petitions and
Complaints Filed in the Court of Federal Claims and the 94 U.S. 
District Courts During 1993.  This publication provides an index of
taxpayers' petitions by tax code section. 


---------------------------------------------------------- Letter :3.1

We are sending copies of this report to congressional committees with
an interest in or jurisdiction over tax matters, the Secretary of the
Treasury, the Commissioner of Internal Revenue, and other interested
parties.  Copies will be made available to others upon request. 

The major contributors to this report are listed in appendix III. 
Please contact me on (202) 512-8633 if you or your staff have any
questions. 

Sincerely yours,

Lynda D.  Willis
Associate Director, Tax Policy
 and Administration Issues


FREQUENT ISSUES IN TAX COURT
PETITIONS FILED PRIMARILY BY SOLE
PROPRIETORS AND SMALLER
CORPORATIONS OVER SECTION 162
BUSINESS DEDUCTIONS
=========================================================== Appendix I

We reviewed 185 petitions filed with the U.S.  Tax Court between
January and mid-May 1993 in which taxpayers contested IRS' findings
on business deductions they took under section 162 of the tax code.\1
The petitions involved tax returns for tax years ranging from 1979 to
1991.  The most common tax years were 1988, 1989, and 1990, which
altogether accounted for 75 percent of the tax years. 

The 185 taxpayers who filed the petitions were primarily sole
proprietors (51 percent of the 185 taxpayers) and small and
medium-sized corporations (31 percent).  Other petitioners were
partnerships, individual shareholders, and individuals claiming
employee business expenses. 


--------------------
\1 We excluded from the petitions we reviewed any petition filed by a
corporation in the IRS' Coordinated Examination Program, which covers
the 1,700 largest corporations in the United States.  We refer to the
remaining corporations--those that filed petitions but were not among
the 1,700 largest corporations--as small and medium-sized
corporations or, at times, "smaller" corporations.  We also excluded
petitions where the amount in controversy exceeded $10 million
regardless of corporate size.  Issues involving the largest
corporations and dollar disputes are discussed in appendix II. 


   MOST COMMON ISSUES OVERALL
--------------------------------------------------------- Appendix I:1

To identify and classify the issues in the Tax Court petitions, we
reviewed the petitions and their attached documents.  The petitions
contained 221 issues in connection with section 162, and the issues
fell into 6 categories. 

  Inadequate documentation.  These issues involved instances where,
     according to IRS, the taxpayer did not (1) provide documentation
     for an expense claimed on a tax return or (2) have all of the
     documentation necessary to deduct a particular type of expense. 

  Unreasonable compensation.  These issues involved closely held
     corporations that, according to IRS auditors, deducted more than
     was "reasonable" for an officer's salary or, in some cases,
     rental property owned by the corporation's officers.  IRS
     classified the excessive amount as a "disguised dividend" to the
     shareholder/officer receiving the salary or the rent and thus
     taxable as corporate or individual income. 

  Not trade or business.  These issues included a variety of
     circumstances where the taxpayer claimed deductions as a
     profit-making trade or business.  IRS disallowed the deductions,
     asserting that the taxpayer was not engaged in a profit-making
     trade or business.  The variety of circumstances included

"hobby" cases where the taxpayer deducted expenses for what IRS
considered to be a recreational activity,

cases where the taxpayer carried on investment activity that IRS said
was not an actual "trade," and

cases where the taxpayer claimed business deductions as an
independent contractor that IRS disallowed because it considered the
taxpayer to be an employee rather than an independent contractor. 

  Personal expenses.  For the issues in this category, the taxpayer
     could document an expense but the IRS auditor concluded that the
     expense was a nondeductible personal expense, such as the cost
     of residential rent, residential utilities, or life insurance
     premiums. 

  Capital expenditures.  In these issues, the taxpayer deducted the
     entire amount of a business expense but IRS said the expense (a
     major repair, for example) had a future benefit and should be
     treated as a capital expenditure. 

  Miscellaneous.  This category included issues such as taxpayers
     claiming business deductions that exceeded a statutory limit on
     the particular type of expense, claiming deductions properly
     taken by another taxpayer, and deducting expenses that IRS
     auditors termed nondeductible fines or penalties. 

Of the six categories, inadequate documentation was the issue
taxpayers most frequently disputed.  Figure I.1 shows the frequency
of the six issues. 

   Figure I.1:  Frequency of
   Issues in Petitions Filed by
   Individuals, Partnerships, and
   Smaller Corporations

   (See figure in printed
   edition.)

Source:  GAO analysis of petitions filed with the U.S.  Tax Court. 

Figure I.2 shows IRS' proposed tax adjustments, which totaled $48.8
million, for the 221 issues.  One issue--unreasonable
compensation--accounted for 50 percent, or $24.5 million, of the
total proposed adjustments.  All of the other categories accounted
for considerably smaller percentages of the total. 

   Figure I.2:  Proposed Tax
   Adjustments by Issue

   (See figure in printed
   edition.)

Source:  GAO analysis of petitions filed with the U.S.  Tax Court. 


   ISSUE OF INADEQUATE
   DOCUMENTATION OFTEN CONNECTED
   TO TAX CODE SECTION 274
--------------------------------------------------------- Appendix I:2

The business deductions challenged by IRS for lack of adequate
documentation included a wide variety of business expenses, such as
advertising and insurance costs, but most often involved
expenses--entertainment, meals, travel, and automobile--that are
specifically addressed in section 274 of the tax code.  Over 40
percent of the petitions we reviewed, where documentation was an
issue, included some dispute over a deduction covered by section 274. 
Expenses under section 274 must meet more rigorous documentation
requirements to be deductible as business expenses than other
expenses generally deductible under section 162. 

To deduct entertainment expenses, for example, a taxpayer must show
not only that the expense is ordinary and necessary in the taxpayer's
trade or business but also that the expense is directly related to or
associated with the taxpayer's business.  For instance, one corporate
taxpayer in the petitions we reviewed had over a dozen season tickets
to all events at a major civic center, and the taxpayer deducted the
cost of those tickets as entertainment expenses.  IRS disallowed most
of the entertainment expenses because, according to the IRS auditor,
the taxpayer could not substantiate the business purpose of that many
tickets and guests.  To meet the requirements of section 274, the
taxpayer had to show (1) that the cost of the tickets was ordinary
and necessary to the corporation's business and (2) that there was a
business connection with each ticket and guest. 

Beyond rigorous requirements for documentation of business purpose,
section 274 has special rules related to certain entertainment and
travel expenses.  To deduct costs of a country club facility, for
example, a taxpayer must show that the club was used "primarily" to
further the taxpayer's business and that the item was directly
related to the conduct of the trade or business.  Thus, in one
petition, a taxpayer who worked part-time as an insurance salesman
and deducted costs of membership in a country club as a business
expense, complained that IRS had not properly considered his business
log showing that he regularly entertained clients at this club. 
However, IRS had disallowed his club expenses because it believed
that he failed to show that over 50 percent of the club use was for
business purposes. 

Among the petitions we reviewed, documentation of automobile and
travel expense were the most frequent sources of dispute.  As an
example, one corporate taxpayer incurred expenses for usage of
automobiles by employees, including some of its shareholders and
officers.  IRS reduced the taxpayer's deduction by over $14,000,
limiting it to the amount directly related to the total miles driven
for business purposes.  At the same time, IRS disallowed over $19,000
in travel and entertainment expenses because the taxpayer failed to
furnish sufficient documentation. 


   MOST COMMON ISSUES IN PETITIONS
   FILED BY SOLE PROPRIETORS
--------------------------------------------------------- Appendix I:3

Sole proprietors--those taxpayers claiming business deductions on
schedule C of their personal income tax returns--filed the largest
percentage of the Tax Court petitions we reviewed, about 51 percent. 
Figure I.3 shows the issues most prevalent among sole proprietors;
two-thirds of the disputes were over proper documentation of business
expenses. 

   Figure I.3:  Frequency of
   Issues in Petitions Filed by
   Sole Proprietors

   (See figure in printed
   edition.)

Source:  GAO analysis of petitions filed with the U.S.  Tax Court. 


   MOST COMMON ISSUES IN PETITIONS
   FILED BY SMALL AND MEDIUM-SIZED
   CORPORATIONS
--------------------------------------------------------- Appendix I:4

At 31 percent, small and medium-sized corporations filed the second
largest percentage of Tax Court petitions that we reviewed.  As seen
in figure I.4, among corporate taxpayers, disagreements with IRS over
the amounts corporations paid their executives were almost as
numerous as disputes over the sufficiency of expense documentation. 
Since the Revenue Act of 1919,\2 IRS has had the authority to
determine whether the amount of compensation paid to a corporate
official and claimed as a business expense is "reasonable."

   Figure I.4:  Frequency of
   Issues in Petitions Filed by
   Smaller Corporations

   (See figure in printed
   edition.)

Source:  GAO analysis of petitions filed with the U.S.  Tax Court. 

For the most part, IRS raised the issue of unreasonable compensation
in audits of closely held corporations.  Where IRS auditors find a
corporate officer's salary to be excessive in amount, the auditors
generally argue that the excessive amount is distribution of the
profits, not compensation for services rendered.  Nearly all
taxpayers petitioning on this issue were closely held corporations
with only a small number of shareholders.  On average, the proposed
tax adjustment for the compensation issue was higher than other
adjustments--$817,000.  In contrast, the average proposed tax
adjustment for issues involving documentation was $89,000.  Examples
of the compensation issue follow. 

A corporation paid its president (and sole shareholder) an average of
about $700,000 in each of 3 successive years.  IRS auditors compared
the president's salary with that of others in the firm, with
comparable salaries in other similar businesses, and with
compensation practices outside of the taxpayer's industry.  On the
basis of these comparisons, the auditors asserted that the company
overpaid its president by about $400,000 each year and proposed an
adjustment of over $1,200,000 to the corporation's tax liability. 

In another case, an individual bought the controlling interest in a
closely held corporation and set himself up as the firm's chief
executive officer.  However, he had a number of businesses in other
states, and he let the corporate president manage the daily affairs
of the corporation.  The corporation paid the chief executive officer
and controlling shareholder an average of $300,000 for several years. 
IRS auditors concluded that the chief executive officer was an
absentee owner paying himself profits rather than compensation on
services rendered, and the auditors proposed a tax adjustment of over
$1 million. 

IRS will consider other factors, particularly salary history, to
determine reasonable compensation.  In one case, two men set up a
firm to do military contract work in the mid-1970s.  In the late
1980s, the corporation markedly increased the salary of both men, and
IRS disallowed nearly $1 million for the years under review.  In
another case, one individual worked for a landfill business for over
20 years.  In one year, the landfill corporation paid this individual
several million in annual compensation.  IRS disallowed all but
$400,000 of this payment. 

The total amount in dispute can involve payments to a number of
corporate officers, all of whom IRS may have determined were paid
excessive amounts.  In one case, IRS disallowed $2.5 million over a
3-year period.  These were compensation payments to five corporate
officers. 


--------------------
\2 Chapter 18, 40 Stat.  1057, Section 214(a) and Section 234(a). 


ISSUES FREQUENTLY DISPUTED BY
LARGE CORPORATIONS OR IN LARGE
DOLLAR CASES INVOLVING SECTION 162
BUSINESS DEDUCTIONS
========================================================== Appendix II

Using data from the Office of Appeals' CENTAUR issue tracking system,
we reviewed 117 cases from IRS' western and southeast regions that
were open in the Office of Appeals as of September 1994.  The cases
involved either a large corporation\1 or tax adjustments exceeding
$10 million in dispute plus some cases where the proposed adjustment
was between $1 million and $10 million and the issue in the case was
being specially tracked by the Office of Appeals.\2 In each case, the
taxpayer was contesting an adjustment proposed by IRS under section
162 of the tax code. 


--------------------
\1 For the purpose of this report, large corporations are those
audited under IRS' Coordinated Examination Program, which includes
the 1,700 largest corporations in the United States. 

\2 The Office of Appeals tracks the issues in its Appeals Coordinated
Issue Program or the Industry Specialization Program. 


   MOST COMMON ISSUES
-------------------------------------------------------- Appendix II:1

CENTAUR contains a summary of the issues in each case.  To identify
and classify the issues in the 117 cases, we reviewed the CENTAUR
summaries.  We identified 219 issues that were associated with
section 162.  For 17 of the issues, the available information was
insufficient for us to categorize the nature of the dispute.  The
remaining 202 issues fell into 9 categories. 

  Capital expenditures.  For issues in this category, the taxpayer
     deducted the costs associated with a corporate acquisition,
     merger, or reorganization or an environmental cleanup.  IRS
     viewed these costs as capital expenditures, not deductible in
     the current tax year. 

  Captive insurance.  In these issues, the corporate taxpayer
     deducted amounts it paid to a wholly owned corporate subsidiary
     for an insurance policy.  IRS will allow the deduction only if
     it determines that the payment is not "self-insurance" but
     rather shifts the risk of loss to another entity. 

  Not trade or business.  Most of the cases and proposed tax
     adjustments for this issue were attributable to one set of tax
     shelter cases.  In these cases, IRS asserted that the taxpayers
     had not set up the business for the purpose designated but to
     shelter income of business investors. 

  Inadequate documentation.  As with the issues in appendix I, these
     issues involved instances where the taxpayer did not provide
     documentation for a claimed expense or did not have all of the
     documentation necessary to deduct a particular type of expense. 

  Not ordinary and necessary.  These issues involved instances where
     IRS challenged an expense that it believed was unnecessary to
     the corporation's business. 

  Stock redemption.  IRS characterized various transactions as stock
     redemptions in these issues.  Section 162(k) of the tax code
     denies deductions for expenses incurred by a corporation in
     connection with redemption of its own stock. 

  Unreasonable compensation.  As with the issues in appendix I, these
     issues generally involved a closely held corporation that,
     according to IRS auditors, deducted more than was "reasonable"
     for an officer's salary.  IRS classified the excessive amount as
     a "constructive dividend" to the officer/shareholder receiving
     the excessive salary. 

  Fraud.  In these issues, IRS alleged that the taxpayer deliberately
     altered records to support a claimed business expense. 

  Miscellaneous.  This category included issues of corporations
     deducting costs of direct lobbying or costs of fines and
     penalties. 

The frequency of each issue is shown in figure II.1.  Figure II.2
presents IRS' proposed tax adjustments for these issues, which
totaled $1.9 billion.  By sizeable margin, the capital expenditure
issue occurred most frequently and had the largest amount of proposed
adjustments.  This is unlike our sample of smaller business taxpayers
discussed in appendix I, where the most frequent issue and the issue
with the largest proposed adjustment were different.  Further, the
issues that dominated our sample in appendix I, documentation and
executive compensation, are found much less frequently in this group
of large corporations and cases. 

   Figure II.1:  Frequency of
   Issues Disputed by Large
   Corporations and in Large Cases

   (See figure in printed
   edition.)

Source:  GAO analysis of IRS CENTAUR data. 

   Figure II.2:  Proposed Tax
   Adjustments by Issue

   (See figure in printed
   edition.)

Source:  GAO analysis of IRS CENTAUR data. 


   MORE INFORMATION ABOUT THE
   CAPITAL EXPENDITURE ISSUE
-------------------------------------------------------- Appendix II:2

As figures II.1 and II.2 showed, the capital expenditure issue was
predominant, accounting for about 4 out of every 10 issues and $1.1
billion of the $1.9 billion in proposed tax adjustments.  Under the
tax code, amounts paid for "capital expenditures" are not deductible
in the current tax year as business expenses under section 162.\3
Further, section 263 of the tax code explicitly requires
capitalization of expenditures for "permanent improvements or
betterments."

At least 31, or more than one-third of the issues involving capital
expenditures, dealt with costs associated with corporate
acquisitions, mergers, and reorganizations.  These costs included
professional fees for legal and investment advice, financing fees,
and other costs incurred in the transactions.\4 In its review, IRS
tries to determine whether the transactions result in a long-term
benefit to the corporation.  If so, IRS' position is that the
expenditure must be capitalized under section 263. 

At least 16 of the capitalization issues involved questions on the
costs of repair or cleanup of land, buildings, or other property. 
IRS examines costs related to environmental cleanups using the same
test it applies to acquisition, merger, and reorganization costs.  If
the expenditure produces significant long-term benefits to the
taxpayer, then the cost should be capitalized as a "permanent
improvement or betterment" under section 263, according to IRS. 


--------------------
\3 Actual tax treatment of a capital expenditure varies.  Generally,
the expenses are added to the capital account or "basis" of the
property involved in the transaction.  Depending on the property, the
costs of improvements may be depreciated over the life of the asset
or used to reduce the amount of the gain realized on the sale of the
asset. 

\4 In this section, we discuss 47 of the 86 issues involving capital
expenditures.  The summary data in CENTAUR allowed us to identify the
issue in all cases.  But for 39 of the capital expenditure issues,
the summary information was not sufficient to allow us to discuss the
facts in the case.  Many of these cases also involved costs of
professional fees but the summary information did not describe the
transaction. 


MAJOR CONTRIBUTORS TO THIS REPORT
========================================================= Appendix III

GENERAL GOVERNMENT DIVISION,
WASHINGTON, D.C. 

Joseph Jozefczyk, Assistant Director, Tax Policy and Administration
Issues
Nancy Peters, Evaluator-in-Charge
Anne Stevens, Senior Economist

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